Replacing conventional system

Replacing interest-based banking by Islamic banking necessitates that banks don’t handle anymore transactions involving interest on both liabilities and asset. While loans are considered as high-return assets of the interest-based system, the change-over to Islamic banking requires the use of Shari’ah compatible techniques. Consequently, there is a need to reduce considerably the role of loans and advances in the assets structure and limit the use of lending as a mode of financing only for businesses that are note able to get financing facilities in other modes.
Financing techniques based on the principle of profit-and-loss-sharing such as Mudarabah and Musharakah are the most suitable alternative for interest-based financing as they meet the financial requirements of productive sectors of the economy and achieve Islamic socio-economic objectives. Mudarabah is a participative arrangement in which one rabb al-mal provides the capital and the Mudarib employs it for business purposes, under this agreement profit from the business will be shared according to specified proportions and without predetermining any fixed amount for any party; in the event of a loss, not resulting from negligence or violation of the terms of the contract by the Mudarib, the entire will be borne by the rabb al-mal. Musharakah is a participative arrangement in which two or more parties enter into a contract of business partnership with well-defined amounts of capital and where all providers of capital are entitled to participate in the management of the business. The profits of this business are distributed according to an agreed ratio whereas loss is to be borne strictly in proportion to the capital invested by each partner. However, the application of Mudarabah and Musharakah in the conduct of banks’ financing operations may be more complex as it requires greater expertise and full commitment and transparency in implementing various procedures.
Islamic teachings also encourage interest-free lending to persons who are in need. And since Banks do not pay any return on resources mobilized by them through demand deposits, they can allocate a certain portion of their resources to Qard Hasan lending. But this portion cannot be significant because banks have to maximize their profitability in order to be able to compete with other institutions in mobilizing depositors’ funds. Besides, managing of interest-free loans involves some costs for the banks; this can be compensated with a service charge which value should be irrespective of the amount of the loan and its duration.
Other techniques, such as Murabahah, Bai’ Muajjal, Salam, Ijarah and Ijarah wa Iqtina’, can also be used to replace interest-based transactions when switching over from the interest-based system to an Islamic interest-free system, especially in cases where there are genuine difficulties in the way of implementing the profit-and-loss principles. These facilities are provided through sales and rental contracts, and thus involve trading for profit and all risks attendant on the purchase and sale of the goods should be borne by the bank until the possession of the goods has been passed to the customer.

Participative modes

Participative financing modes provided under profit-sharing arrangements are the most recommended forms of Islamic financing arrangements because they optimize the utilization of productive resources and provide considerable opportunities to generate economic development. Therefore, Mudarabah and Musharakah are regarded by Islamic scholars and economists as the ideal substitute for interest-based financing as they would guarantee an equitable distribution of income and wealth and would enable banks to use their resources to support businesses and projects based on their viability.
A banking system based on participative modes of financing would stimulate overall productive activity, generate maximum employment and encourage innovations which is the mainspring of growth. The fact that profit-and-loss-sharing arrangement ties up the return on investment with the actual performance of an enterprise; would promote greater allocative efficiency and productivity maximization thanks to with the association of banks and business enterprises. And unlike conventional lending modes, participative modes of financing enable more flexibility for businesses in a loss situation that would have leaded them to bankruptcy in an interest-based system. Therefore, entrepreneurs will be less reluctant to change and more inspired in experimenting new techniques of production to propose innovative products and services. Moreover, a number of conditions have been set in participative modes to preserve the interests of the all parties and it is required that all the partners are provided with information about the operations of the business and its financial situation at regular intervals.
In addition, under the Islamic system, banks choice of ventures to finance is not limited to those ventures with which their capital is safe and which can generate a cash flow to meet their interest liability. The efficiency of a business in resource allocation is judged by the profitability of its production but Islamic banks keep also in view social objectives for the benefit of human beings and society. This would allow individuals and businesses that do not satisfy key criteria of creditworthiness, to have opportunities of investment and creation that were not offered to them in the conventional system.